India Financial sector: Stress recognition picks up

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Updated: February 22, 2016 2:32:53 AM

Indian banks’ NPLs (non-performing loans) jumped an unprecedented 30% in Q3 following the RBI audit and are likely to move-up further to ~6.6% of loans by March 16 as most banks deferred the impact over two quarters.

Indian banks’ NPLs (non-performing loans) jumped an unprecedented 30% in Q3 following the RBI audit and are likely to move-up further to ~6.6% of loans by March 16 as most banks deferred the impact over two quarters. Provision coverage has also slipped to 43%. NPL slippages during the quarter alone was ~1.8% of loans and over the second half of 2016 is expected to be ~3% of loans. Even post this, we believe the full stress asset clean-up is yet to run its course as: (i) divergences in stress corporate NPL classification have increased further post the audit; (ii) still only 10-20% of steel loans are impaired for most banks; (iii) majority of ‘House of Debt’ groups’ stress is still neither NPL or restructured; and (iv) loan growth to stress sectors (power, steel) continues to be high.

PSU banks report losses; retail pvt lenders remain bright spot

PSU banks reported a spike in NPL provisions ~3.3% of loans (annualised) on large RBI audit related impairments. Operating performance was affected as well as NII (net interest income) growth turned –ve resulting in pre-prov profits declining 9% y-o-y. Earning power for the banks has diminished as there has been a sharp increase in impaired loans on the bank’s balance sheets. This would further diminish the banks’ capacity to make adequate provisions for the problem loans.

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Divergence in performance between private corporate and retail lenders increased further as private corporate lenders (ICICI, Axis) also saw a rise in impairments. Retail lenders continue to report strong growth (25%+y-o-y) and are gaining market share at the expense of corporate lenders.

Total NPL for the system increased to 6.1% of loans and ~7.6% for the PSU banks. Even adjusting for the audit impact, slippages were much higher as the banks took the opportunity to clean up their books. PSU banks reported NPL slippages at 1.5-4% of loans during Q3 with most of the banks likely to take a similar impact in Q4 as well. BOB decided to take the full impact in Q3 itself resulting in elevated slippages.

Large number of PSUs under stress

A large number of PSU banks are now under severe stress with total impaired asset levels at >15% (more than 30%) and un-provided problem loans at >100% of net worth (more than 60%). Post the next quarter results, the level of reported impaired assets for these weaker banks will likely go up further. Average NPA for the PSU banks is likely to reach 8% by March 2016. Under-provisioning has gone up sharply with unprovided problem loans for ~60% of banks (by loans) already above 100% with the share likely to move up by March 2016. NPLs as a percentage of net worth are at 50-70% for the majority of PSU banks.

Full stress recognition yet to happen

Even post this, we believe the full stress asset clean-up is yet to be undertaken as: (i) divergences in stress corporate NPL classification have increased further post the audit; (ii) still only 10-20% of steel loans are impaired for most banks; (iii) majority of ‘House of Debt ‘groups’ stress is still neither NPL or restructured; and (iv) loan growth to stress sectors (power, steel) continues to be high.

Recognition still low from power & steel sector

The sector is struggling with an unsustainable level with these capacities unlikely to become profitable even if steel prices recover significantly. Almost ~86% of steel sector debt is with companies under a high degree of stress and this compares with only ~10-20% of steel exposure recognised as NPA by most of the banks. Similarly for “House of Debt” groups recognition has primarily happened from the steel sector and remains quite low. With a large number of operational and under construction projects for these groups struggling, an increase in impairments is likely.

Core profitability continues to weaken

Operating performance also deteriorated for the corporate lenders, in particular the PSUs. Most have been unable to grow their loan books in the past nine months and with NIMs under pressure, pre-provision profitability has weakened further. PSU banks have been fast losing market share to private banks, with a large number of banks reporting flat to – ve growth for 9M16. At the current pace private banks will likely gain 2-3% market share per year. However this may normalise as overall system loan growth picks up.

NII growth turned –ve on large interest reversals and is likely to remain under pressure given large non-performing loans on the banks’ books. A shift to the MCLR regime and a further cut in base rates is also likely to keep NIMs under pressure.

Fee income growth recovered to ~9%; however given muted NII and positive opex growth cost income increased further for PSU banks. Pre-provisions profit growth was –ve (down 9% y-o-y) primarily on account of weak NII (-ve 4% y-o-y) impacted by interest reversal on impaired loans. With the level of problem loans having increased to ~14% for PSU banks and likely to go up further, earning power for the banks would be significantly impaired. Pre-prov ROAs (return on assets) are likely to remain low at 1-1.3% for most PSU banks.

By March 2016, we expect most of the PSU banks (excl SBI) to have unprovided problem loans of more than 100%. Given the large under-provisioning level, banks with weak core profitability would struggle to provide for these bad loans. These banks are going to need capital infusion to bring down the level of problem loans.

Capital needs remain large

Operating performance also deteriorated for the corporate lenders, in particular the PSUs. With the increasing provisioning needs and weakening P&L (11 banks reported losses), recap needs for the PSUs have increased further and we now estimate they are likely to need $34–$53 bn of capital.

Tier I for most of the PSU banks remains low at <8.5% even after negative loan growth and capital infusion by the government on account of large slippages and consequent losses. We estimate a total growth capital need of $21 bn for 12% RWA growth going up to $34 bn if loan growth picks up. Further if the banks clean up the books completely, capital need would go up to ~$53 bn.

Prefer retail lenders

While PSU banks have fallen 35-60% over the past six months and nominal price-to-book is at 0.3–0.6x, we continue to remain negative on weak profitability, a high level of problem assets and dilution risk. Stress recognition is yet to fully run its course, and further, on price to adjusted book valuation doesn’t appear too in-expensive. Performance of retail banks in the current quarter reinforces our positive view as they continue to gain market share on the back of robust growth and have delivered impeccable asset quality. Our top picks are HDFC Bank and IndusInd Bank.

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